What Goes Up, Must Come Down
One of the greatest minds in history and an important figure in modern math and science, Isaac Newton, once said “what goes up, must come down.” Now, while this was a statement about what would eventually be known as gravity, its scope extends well beyond Sir Newton’s primary area of expertise of natural philosophy. In fact, Newton’s philosophy is actually applicable to almost all aspects of life. Under careful and purposeful analysis, our world, and everything in it, is subjected to cycles; and the financial markets are no different. Rapid growth and expansion precede a stagnant economic period, and the market slowly climbs its way back to where it began.
These cycles are not random, however. Each stage of the economic cycle shows warning signs before firmly announcing its presence. One of the best indicators of the health of a market is interest rates, as they essentially dictate all participating parties’ willingness to spend, lend, and borrow. Investopedia defines the term ‘interest rate’ as the amount charged, expressed as a percentage of principal, by a lender to a borrower for the use of assets. Essentially, the interest rate on a loan is a fee, as a percentage of the amount borrowed, that the lender charges the borrower for investing money that does not technically belong to them. When interest rates are lower, consumers pay less in interest and are therefore motivated to spend more money on a new pair of shoes, travel, or an evening out with friends. When interest rates are higher, the opposite is true. In a capitalist economy, growth is triggered through transactions. The greater the volume of transactions, the greater the growth of the economy. Therefore, an economy with low interest rates dictates growth, while an economy with high interest rates predicts a period of small or even negative growth. In basic terms, when interest rates are lower consumers have more disposable income, and therefore more money in their budget to buy a new pair of jeans.
Looking at historical data, interest rates are a key indicator of the next downturn in economic growth. Almost all major recessions, from the U.S. savings and loans crisis in the early 1980’s, to the tech bubble at the turn of the century, to the Great Recession in 2008, have taken place after a spike in interest rates. So, what does that mean for the current economic cycle?
Currently, the United States economy is in its longest growth stage in the history of the country. The Standard & Poor 500, or S&P 500, is a stock market index comprised of the 500 largest companies listed for trading on the New York Stock Exchange or NASDAQ. As a result, the S&P 500 is considered one of the most accurate indices for tracking the overall market trends. Since its lowest point in 2009 after the Great Recession, the S&P 500 has gained over 300 percent. To put it simply, the stocks included in the S&P 500 have collectively tripled in value in a matter of about 9 years.
In September, the Federal Reserve increased the benchmark rate, or the minimum rate investors will demand for a non-treasury security, by a quarter of a percentage point. The benchmark rate is important to the lending world, as it helps to determine the interest rate at which an individual or institution can borrow funds. Investors expect another increase in interest rates at the Fed’s meeting in December 2018. Furthermore, many Federal Reserve officials expect three additional increases in interest rates over the next year. Concerned investors, including the President, Mr. Donald Trump, have expressed dissatisfaction with the Fed’s decision to increase rates at such a rapid pace. Critics cite, for example, the inflation level of 2 percent annually which is regarded by the Federal Reserve as healthy. As of September 2018, data the Bureau of Labor Statistics shows that the Consumer Price Index, or a measure of the change in price in a market basket of consumer goods, is 2.3%. If it were significantly lower than 2%, the argument could easily be made that interest rates should be left unchanged. If it were significantly higher than 2%, then it would make sense for interest rates to be increased. It is crucial to understand, once again, that interest rates have a large influence on the strength of the economy. Those unhappy with the rising rates are concerned that it will put a damper on market activity, lowering the number of transactions being made and therefore stunting the steady growth of the economy.
As rates rise, borrowers have a harder time paying back their debts. Those affected most severely are short-term borrowers. For example, individuals holding credit card debt. Eventually, many could default on their debts. A string of such defaults can cause a serious economic issue. As we saw in 2008 with the downfall of the housing market, bankruptcy claims were filed by some of the largest banks in the United States. Both Lehman Brothers, an investment bank with almost $700 billion in assets, and Washington Mutual, a savings-and-loan holding company with over $300 billion in assets, filed for Chapter 11 bankruptcy just weeks apart from each other in September of 2008. These were the two largest bankruptcies in American history.
Now, to make the issue more tangible, let’s focus on how this issue affects the world of commercial real estate. With the failure of many financial institutions, such as banks and insurance companies in 2008, the government placed more restrictions and regulations on regulated lenders. As a result, banks and other government regulated institutions became more selective in granting loans to individuals and institutions. With a dearth in debt left by traditional lenders, privately owned debt funds stepped in with the intention of filling said void. In simpler terms, the amount of debt issued in the economy decreased, and as a result many individuals and institutions were lacking the funding they needed to make transactions affecting the economy’s ability to grow. Today, real estate private debt funds have $57 billion to invest in other firms and new projects, a record high. By the end of the second quarter in 2018, banks and thrifts held only 52.4 percent of the total $4.17 trillion commercial real estate debt held by lenders.
With the massive amounts of capital in the hands of banks, who have exponentially recovered since 2008, and the private debt funds involved in providing capital to borrowers, competition to inject their own capital into the red-hot lending market is heating up. This raises a few concerns. Some more bearish analysts state that vast influxes of money into real estate debt creates overbuilding and the prospect of riskier construction. Not only that, but with banks competing with unregulated, privately owned debt funds for borrowers, many analysts express concerns that lending standards are being tested.
Going back to the theme of the 2008 Great Recession, market skeptics have default risk on their minds. Interest-only loans composed 73% of all commercial mortgage backed securities in the 9 months before September. These loans are riskier, as the potential for property values to decrease or interest rates to increase greatly affects the borrower’s capacity to make the lender whole.
Considering the consensus that interest rates will rise relatively rapidly over the next year, combined with the massive amount of debt and the loosening of lending and building standards in the commercial real estate markets, it is easy to foresee a downturn in the economic cycle very soon. The U.S. economy has been riding a record long period of expansion, and all signs point toward a correction. As Isaac Newton has predicted, time and time again, “what goes up, must come down.” After an unprecedented period of growth, this economic downturn is not a question of if, but when.
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